Financial Sector Reforms

Financial sector refers to the part of the economy which consists of firms and institutions that have the responsibility to provide financial services to the customers of the commercial and retail segment. The financial sector can include commercial banks, non banking financial companies, investment funds, money market, insurance and pension companies, and real estate etc. The financial sector is considered as the base of the economy which is essential for the mobilization and distribution of financial resources.

The financial sector reforms refer to steps taken to reform the banking system, capital market, government debt market, foreign exchange market etc. An efficient financial sector is necessary for the mobilization of households savings and to ensure their proper utilisation in productive sectors. Before 1991, the Indian financial sector was suffering from several lacunae and deficiencies which had reduced their quality and efficiency of operations. Therefore, financial sector reforms had become essential at that time.

Reasons for financial sector reforms in India

  • After independence, India inherited various deprivations and problems due to colonial legacy. The country was lagging behind in social as well as economic affairs. To attain the goal of rapid economic development, India adopted the system of planned economy based on the Mahalanobis model. This model had started showing its limitations in the mid-80s and early nineties.
  • The government adopted the strategy of fiscal activism for economic growth and large doses of public expenditure were financed by heavy borrowings at concessional rates. This was responsible for comparatively weak and underdeveloped financial markets in India.
  • Due to the policy of Fiscal activism, the fiscal deficit increased year after year. The policy of automatic monetization of Fiscal deficit had inflationary tendencies and other negative impacts on the economy.
  • The nationalisation of Banks had given complete control over these banks to the government, which resulted in the limited role of market forces in the financial sector.
  • The growth rate was hovering around 3.5 % per annum before 1980, and it reached around 5% in the mid-1980s. This growth rate was proving insufficient to solve the economic and financial problems of the country.
  • Lack of transparency and professionalism in the banking sector and issues of red-tapism had been responsible for the increase of non performing assets.
  • There were issues of inadequate level of proper Regulation in the financial sector. The technologies used in the financial system and their institutional structures were outdated.
  • By 1991, India was facing several economic problems. The war in the Middle East and the fall of USSR had put pressure on the Foreign Exchange Reserves of India. India was facing the balance of payment crisis and reforms were now inevitable.

The strategy adopted by India for Financial Sector Reforms

  • To initiate financial reforms, India adopted the path of gradual reforms instead of Shock Therapy. This was necessary to ensure continuity and stability of the financial sector in India.
  • India incorporated International best practices at the same time adjusted it as per the local requirements.
  • The first generation reforms aimed to create an efficient and profitable financial sector by ensuring flexibility to operate with functional autonomy.
  • The second generation reforms were incorporated to strengthen the financial system through structural improvements.
  • India adopted the policy of consensus driven approach for liberalisation as this was necessary for a democracy.

Financial sector reforms in India

Narasimham Committee report, 1991

The Narasimham committee was established in August 1991 to give comprehensive recommendations on the financial sector of India including the capital market and banking sector. The major recommendations made by the committee are

  • To reduce the cash reserve ratio CRR and the statutory liquidity ratio SLR- The committee recommended reducing CRR to 10% and SLR to 25% over the period of time.
  • Recommendations on priority sector lending- the committee recommended to include marginal farmers, small businesses cottage industries etc in the definition of priority sector. The committee recommended for fixing at least 10% of the credit for priority sector lending.
  • Deregulation of interest rates- the committee recommended deregulating the interest rates charged by the banks. This was necessary to provide independence to the banks for setting the interest rates themselves for the customers.
  • The committee recommended to set up tribunals for recovering loans of non-performing assets etc. It gave recommendations on asset quality classifications.
  • The committee recommended for entry of new private banks in the banking system.

Banking sector reforms

  • Changes in CRR and SLR: One of the most important reforms includes the reduction in cash reserve ratio (CRR) and statutory liquidity ratio (SLR). The SLR has been reduced from 39% to the current value of 19.5%. The cash reserve ratio has been reduced from 15 % to 4%. This reduction in the SLR and CRR has given banks more financial resources for lending to the agriculture, industry and other sectors of the economy.
  • Changes in administered interest rates: Earlier, the system of administered interest rate structure was prevalent in which RBI decided the interest rate charged by the banks. The main purpose was to provide credit to the government and certain priority sectors at concessional rates of interest. The system has been done away and RBI no longer decides interest rates on deposits paid by the banks. However, RBI regulates interest on smaller loans up to Rs 2 lakhs on which the interest rate should not be more than the prime lending rates.
  • Capital Adequacy Ratio: The capital adequacy ratio is the ratio of paid-up capital and the reserves to the deposits of banks. The capital adequacy ratio of Indian banks had not been as per the international standards. The capital adequacy of 8% on the risk-weighted asset ratio system was introduced in India. The Indian banks had to achieve this target by March 31, 1994, while the foreign Bank had to achieve this norm by 31st March 1993. Now, Basel 3 norms are introduced in India.
  • Allowing private sector banks: after the financial reforms, private banks we are given life and HDFC Bank, ICICI Bank, IDBI Bank, Corporation Bank etc. were established in India. This has brought much needed competition in the Indian money market which was essential for the improvement of its efficiency. Foreign banks have also been allowed to open branches in India and banks like Bank of America, Citibank, American Express opened many new branches in India. Foreign banks were allowed to operate in India using the following three channels:
    • As foreign bank branches,
    • As a subsidiary of a foreign bank which is wholly owned by the foreign Bank,
    • A subsidiary of a foreign bank within maximum foreign investment of 74%
  • Reforms related to non performing assets (NPA): non performing assets are those loans on which the loan installments have not been paid up for 90 days. RBI introduced the recognition income recognition norm. According to this norm, if the income on the assets of the bank is not received in two quarters after the last date, the income is not recognised. Recovery of bad debt was ensured through Lok adalats, civil courts, Tribunals etc. The Securitisation And Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act was brought to handle the problem of bad debts.
  • Elimination of direct or selective credit controls: earlier, under the system of selective or direct credit control, RBI controlled the credit supply using the system of changes in the margin for providing a loan to traders against the stocks of sensitive commodities and to the stockbrokers against the shares. This system of direct credit control was abolished and now the banks have greater freedom in providing credit to their customers.
  • Promotion of microfinance for financial inclusion: for the promotion of financial inclusion, microfinance scheme was introduced by the government, and RBI the gave guidelines for it. The most important model for microfinance has been the Self Help Group Bank linkage programme. It is being implemented by the regional rural banks, cooperative banks, and Scheduled commercial banks.

Reforms in the government debt market

  • The policy of automatic monetization of the fiscal deficit of government was phased out in 1997 through an agreement between the government and RBI. Now the government borrows money from the market through the auction of government securities.
  • The government borrows the money at market determined interest rates which have made the government cautious about its fiscal deficits.
  • The government introduced treasury bills for 91 days for ensuring liquidity and meeting short-term financial needs and for benchmarking.
  • Foreign institutional investors were now allowed to invest their funds in the government securities.
  • The government introduced the system of delivery versus payment settlement for ensuring transparency in the system.
  • The system of repo was introduced for dealing with short term liquidity adjustments.

Role of regulators

  • Importance of the role of the regulator was recognised and RBI became more independent to take decisions. More operational autonomy was granted to RBI to fulfill its duties.
  • The Securities and Exchange Board of India (SEBI) became an important institution in managing the securities market of India.
  • The insurance regulatory and Development Authority was an important institution for initiating reforms in the Insurance sector. Its responsibilities include the Regulation and supervision of the Insurance sector in India.

Reforms in the foreign exchange market

Since 1950s, India had a highly controlled foreign exchange market and foreign exchange was made available to the Reserve Bank of India in a very complex manner. The steps taken for the reform of the foreign exchange market were:

  • In 1993, India moved towards market based exchange rates, and the current account convertibility was now allowed. The commercial banks were allowed to undertake operations in foreign exchange.
  • The Rupee foreign currency swap market has been developed. New players are now allowed to enter this market and undertake currency swap transactions subject to certain limitations.
  • The authorised dealers of foreign exchange were now given the permission for activities such as initiating trading positions, borrowing and investing in foreign markets etc. subject to certain limitations and regulations.
  • The foreign exchange Regulation Act, 1973 was replaced by the foreign exchange management Act, 1999 for providing greater freedom to the exchange markets.
  • The foreign institutional investors and non-resident Indians were allowed to trade in the exchange-traded derivatives contracts subject to certain regulations and limitations.

Other important financial sector reforms

  • Some important steps were taken for the non-banking financial companies for the improvement of their productivity, efficiency, and competitiveness. Many of the non-banking financial companies have been brought under the regulation of Reserve Bank of India. Many of the other intermediaries were brought under the supervision of the Board of Financial Supervision.
  • In 1992, the Monopoly of UTI was ended and mutual funds were opened for the private sector. The mutual fund industry is now controlled by the SEBI Mutual Funds regulations, 1996 and its amendments.
  • In 1992, the Indian capital market was opened for the foreign institutional investors in all the securities.
  • Electronic trading was introduced in the National Stock Exchange (NSE) established in 1994, and later on in the Bombay Stock Exchange (BSE) in 1995.

Assessment of financial sector reforms

  • After the financial sector reforms, the resilience and stability of Indian economy have increased. The growth rate up the economy has increased from around 3.5 % to more than 6% per annum.
  • The country has been able to deal with the Asian economic crisis of 1977-98 and the recent Global subprime crisis which affected the banking system of the world but did not have much impact on the economy of India.
  • The banking sector and Insurance sector have grown considerably. The entry of private sector banks and foreign banks brought much-needed competition in the banking sector which has improved its efficiency and capability.
  • The Insurance sector has also transformed over the period of time. All these have benefited the customer with diversified options.
  • The stock exchanges of the country have seen growth and stability, and it has adopted the international best practices.
  • RBI has effectively regulated and managed the growth and operations of the non-banking financial companies of India.
  • The budget management, fiscal deficit, and public debt condition have improved after the financial sector reforms. The country is moving with more such future reforms in different sectors of the economy.
  • However, all the issues of Indian economy have not been resolved. The social sector indicators such as the provision of health facilities, quality of education, empowerment of women etc have not been at par with the economic growth.
  • Further, the new issues like the recent rise in non-performing assets of banks, slow growth of investments in the economy, the issues of jobless growth, high poverty rate, a much lower growth rate in the agriculture sector etc need to be resolved with more concrete efforts.

Way forward

The overall impact of the financial sector reforms has been positive. However consistent reforms are needed to maintain the economic growth and make it inclusive of all the sections of society. The recent measures taken by government includes the bankruptcy and insolvency code for resolution of non performing assets, the indradhanush strategy for strengthening the banking sector, the goods and services tax for making India a unified market, single window clearance to remove red tapism and bring transparency, startup India scheme and standup India scheme to boost economic growth in the country etc. India has reached among the top 100 in the ease of doing business of World Bank. But continued efforts are required to sustain and improve the economic growth rate.

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